Working capital management
Two additional ways in which finance can be raised within a business is through the management of working capital.
Working capital is the difference between a company’s current assets and current liabilities.
Working capital = current assets − current liabilities
The working capital formula measures a company’s short-term liquidity. The components of working capital can be ‘managed’ for financing purposes. There are two main ways of managing working capital to provide funds for the business:
- Depending on the specific type and condition of the products, reducing inventory levels (that is, selling the accumulated stocks) can provide short-term funding. However, a business should be aware of the risks that reducing inventories can carry, for example not being ready to accommodate any sudden increases in demand for its products.
- Businesses may also manage their cash flows to provide liquidity by operating with negative working capital. This is the situation when the outstanding amounts due to creditors (payables) exceed those due to be received from customers (receivables). The ability to raise liquidity with negative working capital will depend on the importance that the business places upon reputation as businesses running negative working capital risk exposure to reputational damage. This could affect the terms on which suppliers are prepared to do business with them.
Activity 3 Working capital in practice
This activity applies what you have learned about working capital to a fictitious company named Cullen’s. Examine the information below and answer the questions that follow.
Cullen’s is a company that owns several supermarkets. The figures in the last available financial statement show that Cullen’s has £850,000 as cash in bank accounts, and £950,000 as inventory. Cullen’s accounts receivables are equal to £700,000, whilst its payables are £2,500,000. In addition, Cullen’s has short-term debt of £300,000 and long-term debt of £200,000.
Question 1
Does Cullen’s show positive or negative working capital?
Discussion
The working capital of Cullen’s is equal to current assets minus total current liabilities, or −£300,000. Therefore Cullen’s shows a negative working capital.
| Cullen’s current assets | Cullen’s current liabilities |
|---|---|
Total current assets = £2,500,000 |
Total current liabilities = £2,800,000 |
Cullen’s working capital = current assets − current liabilities =
£2,500,000 − £2,800,000 = −£300,000
Question 2
Should Cullen’s financial managers be worried about the working capital figure you obtained in Question 1? Why?
Discussion
Operating with negative working capital is not intrinsically a bad condition, and it is fairly common in grocery stores. In fact, these businesses can generate cash very quickly. This is because in food retailing, goods are turned into cash at the checkout counters long before the suppliers are due to be paid. This allows such organisations to manage their cash flows with the intention of using them to provide liquidity, with the creditors providing an interest-free loan for the business.